JPMorgan Chase Bank N.A. agreed to pay $135 million to settle SEC charges of improper handling of prereleased American Depositary Receipts during 2011 through 2015. The settlement marks the eighth action against a bank or broker resulting from the SEC’s investigation into improper ADR prerelease practices and means that all four large depositary banks have now been charged. JPMorgan agreed to disgorge more than $71 million, plus interest, and pay a $49.7 million penalty, an amount that factors in its cooperation (In the Matter of JPMorgan Chase Bank, N.A., Release No. 33-10600, December 26, 2018).

Sanjay Wadhwa, Senior Associate Director of the SEC’s New York Regional Office, said that now that all four big depositary banks have been charged, the SEC will continue to investigate brokerage firms that profited through the ADRs.

Prereleased ADRs. ADRs represent an ownership interest in foreign securities that have been deposited with a depositary such as JPMorgan. In the case of a sponsored ADR, there is a deposit agreement among the foreign issuer, the depositary, and ADR holders. With unsponsored ADRs, the agreement is just between the depositary and the ADR holders. The depositary files a Form F-6 registration statement, which includes the deposit agreement and the form of ADR as exhibits; Form F-6 may be used to register the offer and sale of ADRs in certain conditions.

Typically, a corresponding number of ordinary shares are delivered to the custodian at the same time the ADRs are issued. In certain situations, however, deposit agreements may allow market participants to obtain newly issued ADRs from the depositary before delivering ordinary shares to the depositary’s foreign custodian. The broker receiving the prereleased ADRs becomes the temporary custodian of the ordinary shares that would otherwise have been delivered to the custodian. The rationale for prerelease transactions was that settlement timing disparities could delay delivery of recently purchased ordinary shares to the custodian. Under this traditional rationale, the prerelease transaction should be closed within a few days after the broker received the purchased ordinary shares.

Failure to investigate representations. The deposit agreements, ADR, and prerelease agreements typically require representations that the prerelease broker or its customer beneficially owns corresponding ordinary shares, assigns its right in those shares to the depositary, and will not take any action inconsistent with the transfer of beneficial ownership. However, contrary to these representations, many of the prereleased ADRs were not in fact backed by ordinary shares, in violation of Securities Act Section 17(a)(3). The resulting inflation of the total number of foreign issuers’ tradeable securities permitted abuses like inappropriate short selling and dividend arbitrage.

JPMorgan understood that the traditional rationale for prerelease transactions was to smooth timing disparities, which typically resolve within a few days. However, the bank conducted prerelease transactions that were outstanding for more than 5, 30, or 100 days. When JPMorgan came close to exceeding the number of prereleased ADRs it was permitted to issue for a particular issuer, the bank called upon brokers to return some of the prereleased ADRs to the bank, but some were unable to do so, and none delivered the ordinary shares that they supposedly held to close out their positions.

The agreements also typically require the prerelease broker or its customer to ensure that foreign withholding taxes are paid and that dividends and tax credits are passed on to the depositary. The order finds that JPMorgan should have recognized the risk that neither the prerelease brokers nor their counterparties had made the foreign tax payments—had they done so, the prerelease transactions would not have made economic sense. Given the economics of these transactions and the likelihood that the prerelease brokers and their counterparties did not beneficially own corresponding ordinary shares, personnel in the Depositary Receipts Division should have done more to ascertain the truthfulness of the brokers’ ownership representations.

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